CAPITAL RATIONING

It is a process of making investment decisions on viable projects where funds are limited. Investments decisions are made given a fixed amount of capital to be invested in viable projects. If a company doesn’t have sufficient funds to undertake all projects with a positive NPV, this is a capital rationing situation.

Causes1) Hard capital rationing 2) Soft capital rationing

Soft capital rationingIt is caused by internally generated factors of the company. It is a self imposed capital rationing by the management of the company. Management may put a maximum budget limit to be spent within a specific period.

Examples/causes of soft capital rationing1) A self imposed budgetary limit where the management puts a ceiling on the

maximum amount to be spent on investments.2) Management may decide against issuing more equity finance in order to maintain

control over the company’s affairs by existing shareholders.3) Management may opt not to raise more equity so as to avoid dilution in the Earning

per share.4) Management may decide against raising additional debt due to the following

reasons:a) To avoid increase in interest payment commitmentb) To control the gearing or operating leverage so as to maximize the financial

risk.5) If a company is small or family owned, its managers may limit the investment funds

available to maintain constant growth through retained earnings as opposed to rapid expansion.

Hard capital rationingIt is externally imposed by the market and is caused by the factors beyond the control of the company. It occurs where the company has exhausted all its borrowing limits and is unable to raise funds externally.Causes of hard capital rationing

1) Economic factors e.g. high interest rates and high inflation2) Perception by investors that the company is risky. Where the company is deemed

risky e.g. in an infant industry or operating in a very competitive market, the investors will not provide funds to that company.

3) High competition for funds by different companies resulting into an increase in the costs of borrowing.

4) Depressed stock exchange. The company’s share market price is very low and so may find it hard to raise funds from the stock market.

Investment outlay NPV Profitability indexProject 1 600 300 1.5Project 2 600 270 1.45Project 3 200 80 1.4Project 4 400 100 1.25

If we had an unlimited budget, we would undertake all projects and we would improve shareholder wealth bysh.750 (sum of the NPVs). With a budget of sh.1000, our decisions will be different. We would choose project 1 and 4. Project 4 is our third best option, but due to constraints of funds, we are forced to choose it.Capital rationing has the potential to misallocate resources. Funds should be diverted to the highest NPV projects.NPV cannot be correctly used to rank projects with different sizes. For example a project may have an outlay of 10000 and an NPV of 6 while another project may have an outlay of 5 and an NPV of 4. Can you say the first project is better since it has a higher NPV? The second project has had a smaller outlay and a higher NPV as a percentage of outlay (4/5) than the first project (6/10000).We should then use another method which captures the size of the investment. Profitability index is an especially useful method because it shows the profitability of each investment per currency invested. When we have capital rationing, projects should be ranked based on Profitability index.

In our above example given by the table, with capital rationing, we should undertake project 1 and 4. We had a budget of 1000 and we have spent only 800. With the remainder, we can either invest in part projects e.g. fraction of either project 2 or 3.

Divisible projectsThese are projects that can be undertaken in parts or in proportions depending on the capital available for investment. In capital rationing situations, where funds available are not enough to the entire project, the remaining funds can be partly invested in the next viable projects.

Divisible projectsThese are projects which cannot be undertaken in portions. They have to be undertaken as a whole. In a capital rationing situation, where funds are not available or are not sufficient to invest wholly in a project then such a project is abandoned. The remainder can be invested in marketable securities.

Single period capital rationing

It is a situation where the company has limited amounts of funds in one investment period only. After that period, the company can access funds from various sources, e.g. issuing shares, borrowing from banks or issuing bonds.

ILLUSTRATION:

ABC Ltd.is considering investing in the following independent projects

Project PV of cash flow Initial cost NPV P I

1 230000 200000 30000 1.15

2 141250 125000 16250 1.13

3 194250 175000 19250 1.11

4 162000 150000 12000 1.0

The company has set a capital limit of sh.300000.

Required: Advice the management on the projects to undertake.

Solution

If there was no capital rationing then all the 4 projects would be accepted coz they have positive NPV. However with capital rationing, the projects have to be compared using PI index. With sh.300,000, we could have invested in three options. Invest in project 1; invest in projects 2 and 3; invest in projects 2 and 4. We will select the option that gives us the highest weighted average profitability index.

A major assumption made in analysis is that the PI index of all projects is excess of one and the unused funds PI is equal to one.

Weighted average PI:

For option 1: 1.15(200/300) + 1.0(100/300) = 1.1

For option 2: 1.13(125/300) + 1.11(175/300) = 1.118

For option 3: 1.13(125/300) + 1.08(150/300) + 1(25/300) = 1.094

Decision: Invest in project 2 and 3 since this results in the highest weighted average PI.

Multiperiod capital rationing

It occurs where the company has limited amounts of funds for a longer duration of time. The capital constraints extend beyond one investment period.

If we assume that it’s possible to undertake fractional projects then the problem can be formulated using linear programming. If the projects are indivisible, however, then integer programming should be used.